Details Matter Bookkeeping


Employee or Independent Contractor?

by | Jan 23, 2023 | Compliance

I hope you aren’t sick of me talking about 1099s yet, because we still have more to talk about!  Let’s talk about the difference between a 1099 contractor and a W2 employee.  Many small businesses hire additional help as contractors because they either don’t want to deal with having to set up payroll and pay payroll taxes or they think because the people only work part-time that they can just be contractors.  Unfortunately, this can be a very costly and dangerous practice.  The IRS really cracks down on anyone they think might not be paying employment taxes and the consequences could be:

  • Penalties of up to 20% of all the wages paid
  • 100% of the FICA taxes – both the employee’s and the employer’s share
  • Criminal penalties of up to $1,000 per misclassified worker
  • Up to one year in prison can also be imposed
  • The person responsible for withholding taxes could also be personally liable for any uncollected tax

So, how do you know if the workers you’ve hired should be considered 1099 contractors or W2 employees?  The IRS uses a 3 step system to determine if a worker is actually an employee:

Behavioral:  Does the company have control or have the right to control what the worker does and how the worker does his or her job?

    • Does the employer control when and where the worker works?
    • Does the employer control how the worker works?
    • Is there an evaluation in place to measure how the work was done?
    • Is training provided on an ongoing basis?

Financial:  Are the business aspects of the worker’s job controlled by the payer?

    • Is the employer controlling the method of payment?
    • Are there unreimbursed expenses?
    • Can the worker work for others?
    • Does the worker have the opportunity to make a profit or loss?

Type of Relationship:  Are there written contracts or employee type benefits (i.e. retirement, insurance, vacation pay, etc.)?  Will the relationship continue?  Is the work performed a key aspect of the business?

    • Is there a written contract between the employer and the worker?
    • Does the employer offer benefits?
    • Does the employer have permanency issues?
    • What types of services are being provided by the worker?

There are also state rules that can be even stricter such as those in California.  Maryland states that: 

a signed agreement declaring that a worker is an independent contractor is not, by itself, enough to establish that fact. The “economic reality” of the work relationship determines the worker’s status, meaning is the worker economically dependent on an employer who can allow or prevent an employee from working? Thus, if two individuals, in fact, stand in the relation of employer and employee to each other, it is irrelevant that the worker has agreed to be called an independent contractor. The measurement, method, or designation of compensation is also of lesser importance, if the relationship of employer and employee in fact exists.”

It’s up to you as the business owner to weigh these factors (and the associated consequences) in determining whether your workers are independent contractors or employees.  You can talk to your bookkeeper, CPA, or business lawyer if you are struggling to make the decision for guidance. If you do choose to move your workers onto payroll, there are many easy and affordable options out there and we’d be happy to make a recommendation.

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